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Fitch Assigns First-Time Rating of 'BB-' to Ocado Group plc, Outlook Stable
June 12, 2017 / 12:33 PM / 5 months ago

Fitch Assigns First-Time Rating of 'BB-' to Ocado Group plc, Outlook Stable

(The following statement was released by the rating agency) LONDON, June 12 (Fitch) Fitch Ratings has assigned a Long-Term Issuer Default Rating (IDR) of 'BB-' to Ocado Group plc (Ocado). The Outlook is Stable. We have also assigned an expected rating of 'BB(EXP)' to its planned seven-year GBP200 million senior secured guaranteed bond.. The assignment of the final ratings is subject to receipt of final bank loan and bond documentation being substantially on the terms as presented to Fitch. Ocado's 'BB-' IDR reflects its favourable market position and competitive advantages as a pure-play online grocery retailer, despite its small scale and the strong competition in food markets in the UK. A lean cost base supports the group's profitability as reflected in solid EBITDAR and FFO margins. These are in line with the ratings, but are counterbalanced by a negative FCF margin, due to current and committed investments to support its distribution platform in 2017 and 2018. As a point of possible vulnerability we also note the strong reliance of its pricing competitiveness on a joint supply agreement with Waitrose (maturing in 2020), and profit dependence on the single distribution arrangements on behalf of Morrisons. The rating is underpinned by moderate leverage and our expectation of deleveraging capacity, as the business matures, along with strong financial flexibility for the rating. KEY RATING DRIVERS Positive Market Share Trend: The rating reflects Ocado's growing market share, especially against the "big four" UK food retailers, which are struggling to manage their multi-format legacy store base whilst running their online operations rather inefficiently. This helps to counterbalance the group's small scale, its narrow geographic diversification (most of UK now), and overall market share position. According to Kantar Worldpanel, Ocado has doubled its market share since end-2014 - helped by the lack of cannibalisation of other channels, and it now accounts for 1.3% of food retail sales as its revenue continues to grow in the low to mid-double digits. This is ahead of the overall online grocery market, which currently has a growth rate of 7.8%. We also estimate Ocado's market share in online grocery retail at around 15%. The calculation excludes Morrison's online operations which are run exclusively on Ocado's Smart Platform. This is an important support to the rating along with Ocado's well-diversified customer base across ages and household income levels. Strong Online Presence: Ocado's dedicated online presence reflected in its unique end-to-end operating solution for online grocery retail based on proprietary intellectual property and technology - and the lack of costs associated with running a brick-and-mortar store network - is a key differentiating factor from competitors. Moreover, the group's ability to offer products that are exclusively supplied via Ocado provides a solid product and service offering. This is supported by more recent brand additions such as Fabled (in combination with Marie Claire), Fetch (pet store) and Sizzle (kitchen and dining) along with its exclusive supply partnership with Waitrose. Manageable Competition: We consider Ocado a disruptive player in the online grocery retail sector. It competes by focusing on improving its customer proposition to support growth and driving efficiency through scale, technology and operational improvements. The rating reflects our view of moderately high barriers to entry in grocery retailing due to low growth rates, rapid e-commerce development, the need to manage different temperature environments (fresh, frozen) in delivering products to consumers, supplier relationships, brand and identity. In the UK, aside from the "big four" retailers which manage online operations as a separate channel but struggle to increase market share, Amazon is also extending its grocery distribution offering - especially in south-east England. However, we do not currently see Amazon as the biggest threat as its service may struggle to achieve the extensive range of products, delivery capabilities and pricing of Ocado. Weak Profitability in 2017-18 to Improve: Ocado has an EBITDAR margin (similar to FFO) of 6%-7% which is solid for a grocery distribution business, especially relative to other online retailers where margins are often very low. This reflects Ocado's right-sized operations and appropriate cost base. We expect some weakness in EBITDAR margins in 2017-18 due to start-up costs associated with new operations of the Andover and Erith Customer Fulfilment Centres (CFCs) at a time of high competition. Over 2017-2018 we expect some downward pressure on gross margins, mitigated by cost optimisation. As we expect sales growth to stay on course, we assume Ocado will naturally benefit from greater operating leverage and should see its EBITDAR margin improve by around 80bp between 2018 and 2020. The rating is predicated upon free cash flow (FCF) achieving break-even in 2019-20 as we think that management will assess new expansionary projects then in light of the competitive landscape and funding environment. IP Licensing Provides Upside: We expect Ocado's cash flows will continue to stem from its own online grocery distribution business over the rating horizon. However, some upside exists from franchising its technology/intellectual property (IP) via its Solutions Business to other retail partners - in addition to other third-party arrangements with Morrisons and Dobbies Garden centres - as well as international retailers wishing to develop their online retail businesses. We expect only moderate absolute sales and profits from such contracts, but these would help diversify the group's income flows, providing some stability and visibility beyond its own retailing platform. Moderate Leverage over Rating Horizon: Ocado has a good record of profitable growth whilst maintaining a prudent balance sheet. Management sees leverage (net debt to EBITDA) of 2.5x as appropriate for the business, with temporary increases possible to accommodate capacity increases. At present the strategy is focused on organic growth with no M&A or dividends, which we believe is sensible. In our view Ocado's conservative financial policy is an important safeguard for the rating. The degree of visibility over the next few years' sales growth mitigates the risk that remaining capex may drag FCF generation through to 2019. We project FFO adjusted leverage will peak at 4.7x, and then fall to 3.4x by 2020, a level fully compatible with a 'BB' rating category for the sector. This financial risk profile represents moderate refinancing risks. In our leverage computation we include 50% of the debt owed to MHE JVCo, in which Ocado and Morrisons own a 50% equity interest, to cover for any operational risks (and service execution) which we believe stays with Ocado, and 50% of debt owed to Morrisons - likely to be paid in service provision over the length of its long-term contract. Considerable Financial Flexibility: Following the planned debt refinancing, we expect Ocado will have sufficient financial flexibility to conduct its capex programme. This is supported by the group's clear commitment to maintain a conservative policy with only modest deviations allowed, a well-spread and long-dated debt maturity profile, and limited FX exposure. Moreover, we expect strong FFO fixed charge cover and EBITDAR to interest plus rents for the rating (in the range of 2.7- 3.7x over the rating horizon), aided by low operating leases. The level of leases is a key reflection of Ocado's different asset and cost base relative to traditional retailers. Above-Average Bond Recovery Expectations: Both the planned bond and RCF are first-lien and secured by pledges over all of the issued share capital of each guarantor. Based on the transitional recovery approach, we believe there is value available as a growing online grocery retailer and as a developing technology provider to attract enough interest from potential trade buyers in the event of distress. This results in the planned notes rated 'BB(EXP)', which is one notch higher than the IDR. The proposed guarantors represented, after deducting intercompany eliminations, GBP88.1 million, or 115.3%, of EBITDA (as defined in indenture) and GBP248.1 million, or 94.6%, of Ocado's net assets for the 52 weeks ended 27 November 2016. Even conservatively taking into account the debt owed to MHE JVCo (as it is not a guarantor of the planned notes and thus the debt at JV will rank senior to the notes), the level of priority debt to EBITDA would equate to around 1.5x. We expect this to fall over time driven by capital amortisation of lease payments staying well below the threshold of 2.0- 2.5x that Fitch considers material to trigger structural subordination for holding-company creditors. DERIVATION SUMMARY Ocado's 'BB-' IDR is well positioned relative to traditional food retail peers on each major comparative except scale and diversification. However, given Ocado's exclusive presence in the online channel, it benefits from positive sector trends which is reflected in its growing customer base and increasing market share in UK grocery as a whole and mostly in online. Ocado's profitability measured as FFO margin and EBITDAR margin trend is stronger than Tesco's (BB+/Stable) but capex will translate into negative FCF in 2017-18. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - increase in average basket size in the financial year to November 2017 (FY17) at a slower pace than inflation; - deterioration in EBITDA margin of up to 80bp by 2018 followed by improvement of similar magnitude by 2020 after completion of the CFC at Erith, on higher operating efficiency; - capex to peak at 12% of sales in FY17, fall to 10% of sales in FY18, and stabilise at around 6% thereafter partly dependent on funding available; - discretionary capex in FY17/FY18 (together almost GBP300 million) to be funded by CFO and proceeds from planned bond offering, around GBP70 million and GBP80 million in 2019/ 20 including technology investments; - no dividend payments over FY17-FY20; - FCF to remain negative in FY17/18 and breaking even in FY19. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -Increasing scale and diversification either linked to greater product mix, continuing growth of its customer base (market share) or new partner retailers under the Solutions Business while maintaining an FFO margin consistently above 5% post-2018 demonstrating a more mature business risk profile -FFO-adjusted gross leverage trending to 3.5x on a sustained basis -Maintenance of solid financial flexibility including strong FFO fixed charge coverage and liquidity available - Prudent growth strategy reflected in higher share of capex funded internally leading to FCF neutral Future Developments That May, Individually or Collectively, Lead to Negative Rating Action - FFO margin erosion to below 3% indicating slower than expected new capacity take up, weaker pricing power and/or intensifying competitive pressure in its own grocery distribution platform - FFO-adjusted gross leverage staying above 4.5x on a sustained basis - Diminished financial flexibility reflected by deterioration of liquidity position as a result of higher capex leading to continuing negative FCF in the mid-single digits of sales, worse working capital turnover, and/or FFO fixed charge coverage below 2.5x on a sustained basis LIQUIDITY Adequate Liquidity: Liquidity is sufficient to meet Ocado's short-term debt obligations and would be improved after the pending transaction of a new GBP200 million bond issue. The size of the RCF would be reduced from GBP210 million to GBP150 million as the cash proceeds from the bond issue will be used to repay the outstanding RCF of GBP87.5 million. The maturity of the RCF would be also extended from July 2019 to June 2022 and it is expected to remain undrawn after the transaction. We expect the group to use the additional liquidity to fund primarily its development of the Andover and Erith CFCs. FULL LIST OF RATING ACTIONS Contact: Principal Analyst Maggie Cheng, CFA Associate Director +44 20 3530 1689 Supervisory Analyst Pablo Mazzini Senior Director +44 20 3530 1021 Fitch Ratings Limited 30 North Colonnade London E14 5GN Committee Chairperson Giulio Lombardi Senior Director +39 02 879087 214 Date of Relevant Committee: 9 June 2017 Summary of Financial Statement Adjustments - GBP5 million deducted from reported cash as restricted cash held by the group's captive insurance company and by the employee benefit trust related to Ocado's employee share scheme in Poland - A multiple of 8x (given the company's location in the UK) used for capitalisation of around GBP12.8 million of annual rental payments - MHE JVCo: We have excluded 50% of GBP108.7m finance leases related to MHE JV Co to reflect Ocado's 50% share (retaining 50% share of capital and interest component of lease payments). We also deduct non-cash elements from EBITDA (MHE lease income and share of MHE JVCo profits) amounting to GBP13.8 million, as well as GBP8.4million in dividend received from the JV from Funds from Operations. Media Relations: Peter Fitzpatrick, London, Tel: +44 20 3530 1103, Email: peter.fitzpatrick@fitchratings.com. Additional information is available on www.fitchratings.com. For regulatory purposes in various jurisdictions, the supervisory analyst named above is deemed to be the primary analyst for this issuer; the principal analyst is deemed to be the secondary Applicable Criteria Criteria for Rating Non-Financial Corporates (pub. 10 Mar 2017) here Recovery Ratings and Notching Criteria for Non-Financial Corporate Issuers (pub. 21 Nov 2016) here Additional Disclosures Dodd-Frank Rating Information Disclosure Form here Solicitation Status here#solicitation Endorsement Policy here ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. 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